Why aren’t we currently buying gold bars, gold Electronically Traded Notes (ETFs), and mining companies? Wouldn’t owning gold offset the (understated) inflation that we see daily and that may soon spiral out of control? While Washington’s Biggest Lie is its denial of real inflation, we believe that pouring money into physical gold, gold-tracking assets, and shares of mining companies, is very risky, even if it makes logical sense. (Gold – The Biggest Risks Are The Ones You Don’t See)

It makes sense because the supply of gold is limited and gold cannot be magically created by the Central Banks. Gold has also been used as a store of wealth for centuries. And of course, gold is presumed to be a good inflation hedge. But is it really?

Going back to 1980, gold peaked at about $850 per ounce. It bottomed in 2000 at about $250 per ounce. Annual inflation in 1980 and 1981 was in the double-digits. Later in the 1980s and through the 1990s, inflation fluctuated from under 2 to over 5 percent, drifting lower over those two decades.

The chart below shows the nominal price of gold beginning in the 1970s. The second chart shows the nominal price of gold from 1979 to July 2012. (Click on charts to enlarge.)

It’s clear that the lines seem correlated back in the 70’s and 80?s, but lose their relationship in the past decade. This makes it difficult to believe that the recent increase in price of gold has been solely due to a change in realized inflation and weakens the case for gold as a good inflation hedge… There isn’t much empirical evidence to make one believe that the decade long gold rally has exclusively to do with either realized inflation, inflation expectations or the federal reserves balance sheet. (Is gold really an inflation hedge?)

In Gold vs. Inflation, Barry Ritholtz noted that the link between gold prices and inflation is limited. The correlation between gold and inflation year over year is 0.42. On a month over month basis, it’s only 0.11. According to Merrill, “Gold is not a great hedge against inflation. Investors would be better off owning TIPS if they are looking for protection against a potential rise in inflation.” (Merrill Lynch via Barry Ritholtz)

Gold prices are unlikely to soar to new heights anytime soon. Paul questioned the wisdom of amassing physical gold, buying gold in a custodian’s care, and loading up one’s portfolio with assets reflecting gold prices:

Recent history shows at least some custodians of your warehoused Gold to have been unreliable. For example, commodity brokerage firms MF Global and Peregrine Financial both failed to protect customer interests in the physical gold ‘safeguarded’ by them.

If you correctly bet on Gold going up you still may never even see your original stake returned, let alone any paper profits. Speculators were willing to risk price fluctuations. They didn’t know they were also subject to outright theft of their property.

Many traders today play Gold movements with ETNs (Electronically Traded Notes) without knowing these have bigger risks than simply the metal’s price action. These ETNs are unsecured obligations of their issuing financial sponsors….

Physical delivery of Krugerrands, American Eagle gold coins and or bullion bars, and holding them in your own safe seems to avoid the custodial problems. Now, word from ZeroHedge.com confirms that Chinese companies have been actively promoting the sale of assorted counterfeit gold plated items ‘for legal purposes only’. (Gold – The Biggest Risks Are The Ones You Don’t See)

Fakes and Frauds

Besides the risks that inflation won’t skyrock and that custodians of your gold-based assets will go belly up, Zero Hedge noted that tungsten is being used to fill fake gold items. A firm called ChinaTungsten Online is marketing its broad ‘tungsten-alloy services.’ These services include “the gold plating of various tungsten formulations among them ‘gold’ bricks, bars and, yes, coins.” The company is openly advertizing its tungsten gold-plating and precious metals replication services.

Zero Hedge also relayed a story about counterfeit gold being found in Manhattan’s Jewelry District. “Myfoxny reported that a 10-ounce gold bar costing nearly $18,000 turned out to be a counterfeit. The discovery was made by the dealer Ibrahim Fadl, who bought the PAMP bar in question from a merchant who has sold him real gold before. ‘But he heard counterfeit gold bars were going around, so he drilled into several of his gold bars worth $100,000 and saw gray tungsten — not gold. The bar was filled with tungsten, which weighs nearly the same as gold but costs just over a dollar an ounce.'”

Will we soon be drilling into the cores of our shiny golden trinkets, bars and coins to test for purity? This is expensive, time-consuming, and decreases value and transferability.

The U.S. Commodity Futures Trading Commission announced Wednesday, it filed a civil injunctive enforcement action in the U.S. District Court for the Southern District of Florida against 12 firms and their executives for fraudulently marketing illegal, off exchange retail commodity contracts…

According to the CFTC complaint, the defendants claim to sell physical metals, including gold, silver, platinum, palladium, and copper, to retail customers in retail commodity transactions. Under the defendants’ retail commodity transactions investment contract, customers allegedly make a down payment on certain quantities of physical metals, usually 25 percent of the total purchase price. Defendants allegedly claim to arrange loans for the balance of the purchase price, and advise customers that their physical metals will be stored in a secure depository.

But the CFTC alleged that the defendants do not purchase any physical metals, arrange loans for their customers to purchase physical metals, or arrange for storage of physical metals for any customers participating in their retail commodity transactions. Instead, all the transactions are just paper transactions, according to the complaint. Defendants allegedly do not own or sell metals to customers; customers are charged storage and insurance fees on metals that do not exist; and are charged interest on loans, which are never made by the defendants… (Fool’s gold? CFTC says 12 firms sell phantom metals)

Mining companies may seem like viable alternative to other gold-based investments involving trusting custodians or stockpiling one’s own gold supply. However, particularly for mining companies with foreign operations, forward estimates and past performance may not be good predictors of future profits.

I used to favor shares of international resource and mining companies as a safer, liquid, back-door play on rising inflation. Worldwide political forces and heavy government debt have been catalysts for repudiation of long-term contracts and unilateral nationalization of foreign assets. This puts downward pressure on the earnings power of resource companies with significant assets in less developed countries.

Argentina-based oil company YPF (YPF) lost about half it value overnight some months ago after local authorities basically seized its assets without fair compensation. Indonesia has threatened to abrogate signed contracts with FCX because it now wants bigger royalties than previously agreed to. Australia is raising taxes dramatically on BHP, which cut back on its development there in protest.

The good old days of paying contractually promised royalties to less developed nations while mining their natural resources appears to be coming to an end. This explains what look like bargain prices on industry leaders like BHP Billiton, Rio Tinto (RIO), Freeport Mc-MoRan (FCX), Newmont Mining (NEM), American Barrick (ABX) and others.

It is not easy to find financial gurus and writers who are currently bearish on gold. There is Warren Buffett, who prefers buying something that generates income. Joe Weisenthal posed the bubble question in writing about Felix Salmon’s attempt to go shopping with a gold bar. “It sounds silly, but if gold is a currency, then it should be usable as a medium of exchange… Felix goes up to a guy loading wholesale beer, and the guy knows instantly (!) what a gram of gold is worth: right around $50! When the guy loading wholesale beer knows the price of a gram of gold instantly, you’ve just got your famous example of the taxi driver giving you stock tips. DANGER!” (This Is The Best Proof We’ve Ever Seen That Gold Is In A Bubble)

Investors who love gold tend to think of it as a sort of bomb shelter. It’s supposed to be a secure place to park your money when the rest of the financial world is blowing up…

In the past decade, much of the new demand that set gold off on a wild tear from around $300-an-ounce at the turn of the century to almost $1,900-an-ounce last year has come from two places: India and China. Combined, they account for 45 percent of the world’s demand for gold jewelry and bars…

For today, let’s focus on China, which passed India as the world’s top gold market earlier this year. The country deregulated its gold market in 2001, and since then, it has gone from consuming about a third as much gold as the developed west to overtaking it by 2011. Let me repeat that: the Chinese buy more gold than the entire west combined…

Just as China’s rich have found new places to invest, the country’s economy has been slowing down frighteningly, which dropped demand for jewelry this last quarter by 9 percent from a year earlier.